Bay Street analyst warns of office real estate exposure for banks

Commercial loans dominate Canadian banks

Bay Street analyst warns of office real estate exposure for banks

Despite having less exposure to commercial real estate than those in the US, an analyst for Bay Street claims that Canada's banks are nevertheless at risk of having their revenues decimated by remote work in the office sector.

According to National Bank Financial analyst Gabriel Dechaine, commercial real estate loans account for approximately 10% of the lending portfolios of Canada's six major banks, following only by residential real estate in terms of proportionate size.

“Not only is the portfolio large, but it has also grown faster than the overall wholesale portfolio over the past seven years,” the analyst noted on May 7.  “Office exposures are particularly worrisome and represent 12 per cent of the average Big-Six CRE (commercial real estate) book.”

Soaring interest rates and remote work are making it difficult for investors and owners of commercial real estate, and work from home set-ups are leaving many office buildings underutilized and affecting rent prospects. The first quarter saw a rise in the U.S. office vacancy rate to 12.9%, breaking the previous record set during the financial crisis of 2008, according to a report from the Wall Street Journal.

Using historical examples such as the financial crisis of 2008 and the recession and real estate downturn in the early 1990s as intermediaries, Dechaine ran settings and concluded that the downside risk to earnings per share could be in a high single digit count or "well over" 20%, though "likely at the lower end" of that variation.

“Of course, in either scenario, earnings downside would be even greater considering that losses would also be incurred in other lending portfolios,” he said.

No significant bank would likely fall below the minimal capital buffers required by regulators, the analyst said despite the possible impact on profitability. Around 70% of the commercial real estate loans in the banking system are held on the balance sheets of banks with less than US$180 billion in assets, according to research by Goldman Sachs Group Inc. Twenty-five percent of the loans made by regional U.S. banks with assets between $10 and $20 billion are secured by commercial real estate.

Despite some exposure to the U.S., Dechaine said that Canadian banks' exposure to weakened commercial real estate loans has not increased dramatically. However, Canadian financial institutions don't provide as much information about set-aside provisions as their American counterparts do. Provisions of two to three percent have been noted by U.S. banks.

“Despite the stellar (Canadian) credit metrics today, investors are undoubtedly questioning coverage ratios, in the event of an actual CRE downturn (particularly in the office category),” Dechaine said.

“With the CRE overhang and the ongoing turbulence in the U.S. regional banking sector that could trigger a recession, we believe most investors will maintain a cautious stance towards the Big 6 banks.”

According to Dechaine's calculations, the three banking institutions—Bank of Montreal, Toronto-Dominion Bank, and National Bank—have about 10% of their assets exposed to office space, with Royal Bank of Canada holding the top spot with about 20%. Regarding the capacity of Canadian banks to withstand exposure to commercial real estate, some market observers have voiced less worry.

The large banks, according to CPA Canada's senior economist David-Alexandre Brassard, are "well positioned" to deal with high vacancy rates and rising interest rates because commercial real estate accounts for 2% of their total assets, compared to 13% for U.S. banks.